Important issues in macroeconomics

2. Important issues in macroeconomics • Why does the cost of living keep rising? • Why are millions of people unemployed, even when the economy is booming? • What causes recessions? Can the government do anything to combat recessions? Should it? Macroeconomics, the study of the economy as a whole, addresses many topical issues:

3. Important issues in macroeconomics • What is the government budget deficit? How does it affect the economy? • Why does the U.S. have such a huge trade deficit? • Why are so many countries poor? What policies might help them grow out of poverty? Macroeconomics, the study of the economy as a whole, addresses many topical issues:

4. 9/11/2001 First oil price shock Great Depression Second oil price shock World War II U.S. Real GDP per capita (2000 dollars) long-run upward trend…

5. U.S. inflation rate(% per year)

6. U.S. unemployment rate(% of labor force)

7. Why learn macroeconomics? 1. The macroeconomy affects society’s well-being. Each one-point increase in the unemployment rate is associated with: • 920 more suicides • 650 more homicides • 4000 more people admitted to state mental institutions • 3300 more people sent to state prisons • 37,000 more deaths • increases in domestic violence and homelessness

8. change from 12 mos earlier percent change from 12 mos earlier Why learn macroeconomics? 2. The macroeconomy affects your well-being.

9. Why learn macroeconomics? 3. The macroeconomy affects politics. Unemployment & inflation in election years year U rate inflation rate elec. outcome 1976 7.7% 5.8% Carter (D) 1980 7.1% 13.5% Reagan (R) 1984 7.5% 4.3% Reagan (R) 1988 5.5% 4.1% Bush I (R) 1992 7.5% 3.0% Clinton (D) 1996 5.4% 3.3% Clinton (D) 2000 4.0% 3.4% Bush II (R) 2004 5.5% 3.3% Bush II (R)

10. A multitude of models • So we will learn different models for studying different issues (e.g., unemployment, inflation, long-run growth). • For each new model, you should keep track of • its assumptions • which variables are endogenous, which are exogenous • the questions it can help us understand, and those it cannot

11. Prices: flexible vs. sticky • Market clearing: An assumption that prices are flexible, adjust to equate supply and demand. • In the short run, many prices are sticky – adjust sluggishly in response to changes in supply or demand. For example, • many labor contracts fix the nominal wage for a year or longer • many magazine publishers change prices only once every 3-4 years

12. Prices: flexible vs. sticky • The economy’s behavior depends partly on whether prices are sticky or flexible: • If prices are sticky, then demand won’t always equal supply. This helps explain • unemployment (excess supply of labor) • why firms cannot always sell all the goods they produce • Long run: prices flexible, markets clear, economy behaves very differently

13. Outline of this course: • Introductory material (Chaps. 1 & 2) and the Classical Theory (Chaps. 3, 4, & 6) How the economy works in the long run, when prices are flexible • Business Cycle Theory (Chaps. 9-12)How the economy works in the short run, when prices are sticky • Policy debates (Chaps. 13-15)Should the government try to smooth business cycle fluctuations? Is the government’s debt a problem? • Growth Theory (Chaps. 7 & 8)The standard of living and its growth rate over the very long run

14. Human Body Machine Metaphors for the Economy

16. Do you remember… …the meaning and measurement of the most important macroeconomic statistics? • Gross Domestic Product (GDP) • The Consumer Price Index (CPI) • The unemployment rate

17. Gross Domestic Product: Expenditure and Income Two definitions: • Total expenditure on domestically-produced final goods and services. • Total income earned by domestically-located factors of production. Expenditure equals income because every dollar spent by a buyer becomes income to the seller.

18. Income ($) Labor Goods Expenditure ($) The Circular Flow Firms Households

19. The expenditure components of GDP • consumption • investment • government spending • net exports

20. Consumption (C) • durable goodslast a long time ex: cars, home appliances • nondurable goodslast a short time ex: food, clothing • serviceswork done for consumers ex: dry cleaning, air travel. definition: The value of all goods and services bought by households. Includes:

21. U.S. consumption, 2007 (Q3) $ billions % of GDP Consumption Durables 1,081.6 7.7 Nondurables 2,846.3 20.4 Services 5,857.8 41.9 $9,785.7 70.0%

22. Investment (I) Definition 1: Spending on [the factor of production] capital. Definition 2: Spending on goods bought for future use Includes: • business fixed investmentSpending on plant and equipment that firms will use to produce other goods & services. • residential fixed investmentSpending on housing units by consumers and landlords. • inventory investmentThe change in the value of all firms’ inventories.

23. U.S. investment, 2007 (Q3) $ billions % of GDP Investment Business fixed 1,500.2 10.7 Residential 627.3 4.5 Inventory 35.4 0.3 $2,162.9 15.5%

24. Investment vs. Capital Note: Investment is spending on new capital. Example (assumes no depreciation): • 1/1/2007: economy has $31,818b worth of capital • during 2007:investment = $2,163b • 1/1/2008: economy will have $33,981b worth of capital

25. Government spending (G) • G includes all government spending on goods and services.. • G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services.

26. U.S. government spending, 2007 (Q3) 990.3 7.1 316.8 2.3 673.5 4.8 1,762.2 12.4 $ billions % of GDP Govt spending $2,716.5 19.5% Federal Non-defense Defense State & local

27. Net exports, 2007 (Q3) NX = EX – IM

28. aggregate expenditure value of total output An important identity Y = C + I + G + NX

29. A question for you: Suppose a firm • produces $10 million worth of final goods • but only sells $9 million worth. Does this violate the expenditure = output identity?

30. Why output = expenditure • Unsold output goes into inventory, and is counted as “inventory investment”… …whether or not the inventory buildup was intentional. • In effect, we are assuming that firms purchase their unsold output.

31. GDP: An important and versatile concept We have now seen that GDP measures • total income • total output • total expenditure

32. GNP vs. GDP • Gross National Product (GNP):Total income earned by the nation’s factors of production, regardless of where located. • Gross Domestic Product (GDP):Total income earned by domestically-located factors of production, regardless of nationality.

33. Discussion question: In your country, which would you want to be bigger, GDP, or GNP? Why?

34. (GNP – GDP) as a percentage of GDP selected countries, 2002

35. Real vs. nominal GDP • GDP is the value of all final goods and services produced. • nominal GDP measures these values using current prices. • real GDPmeasure these values using the prices of a base year.

36. Practice problem, part 1 • Compute nominal GDP in each year. • Compute real GDP in each year using 2006 as the base year.

37. Answers to practice problem, part 1 nominal GDPmultiply Ps & Qs from same year2006: $46,200 = $30  900 + $100  192 2007: $51,400 2008: $58,300 real GDPmultiply each year’s Qs by 2006 Ps2006: $46,2002007: $50,000 2008: $52,000 = $30  1050 + $100  205

38. Real GDP controls for inflation Changes in nominal GDP can be due to: • changes in prices. • changes in quantities of output produced. Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.

39. U.S. Nominal and Real GDP, 1950–2006 Real GDP(in 2000 dollars) Nominal GDP

40. GDP Deflator • The inflation rateis the percentage increase in the overall level of prices. • One measure of the price level is the GDP deflator, defined as

41. Practice problem, part 2 • Use your previous answers to compute the GDP deflator in each year. • Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

42. Answers to practice problem, part 2

43. Consumer Price Index (CPI) • A measure of the overall level of prices • Published by the Bureau of Labor Statistics (BLS) • Uses: • tracks changes in the typical household’s cost of living • adjusts many contracts for inflation (“COLAs”) • allows comparisons of dollar amounts over time

44. How the BLS constructs the CPI 1. Survey consumers to determine composition of the typical consumer’s “basket” of goods. 2. Every month, collect data on prices of all items in the basket; compute cost of basket 3. CPI in any month equals

45. Exercise: Compute the CPI Basket contains 20 pizzas and 10 compact discs. For each year, compute • the cost of the basket • the CPI (use 2004 as the base year) • the inflation rate from the preceding year prices: pizza CDs 2004 $10 $15 2005 $11 $15 2006 $12 $16 2007 $13 $15

46. Answers: Cost of Inflation basket CPI rate 2004 $350 100.0 n.a. 2005 370 105.7 5.7% 2006 400 114.3 8.1% 2007 410 117.1 2.5%

47. The composition of the CPI’s “basket”

48. Reasons why the CPI may overstate inflation • Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen. • Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights. • Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured.

49. The size of the CPI’s bias • In 1995, a Senate-appointed panel of experts estimated that the CPI overstates inflation by about 1.1% per year. • Now, the CPI’s bias is probably under 1% per year.

50. CPI vs. GDP Deflator prices of capital goods • included in GDP deflator (if produced domestically) • excluded from CPI prices of imported consumer goods • included in CPI • excluded from GDP deflator the basket of goods • CPI: fixed • GDP deflator: changes every year